Regulatory best practices applied to district heating Future of Heat Markets and DH Pricing in Baltic Countries and Poland workshop, Riga Dr Leonardo Mautino Managing Consultant
Overview - context: models of regulation - overview of RAB/WACC - approach and recommendations - implementation 2
Choice of regulatory approach Competition and market failures Choice of regulatory approach Energy policy objectives Effectiveness of competition DH has enduring monopoly characteristics DH has a degree of market power, but the market is contestable DH is subject to effective competitive pressures Increasing competitive pressures on DH Regulatory approach Cost-based approaches (eg, RAB/WACC) Market-based approaches (eg, alternativebased pricing) Light-touch approaches (eg, price monitoring) 3
Specific models of regulation Market-based approaches - aim to deliver economically efficient price signals - more relevant where there is a prospect of competition - imply cash-flow uncertainty and possible perception of over-recovery - risk of asset-stranding Cost-based approaches - aim to reduce investment risk and to guarantee cost recovery - mostly relevant where the activity has enduring market power - may imply limited upside of high-return scenarios LRIC-based pricing Reflects hypothetical competition with alternative/new technologies (eg, telecoms) Alternativebased pricing Reflects possible competition with different providers/ technologies (eg, DH) Cost-plus Constrains profits, but provides few incentives for efficiency Price (revenue) cap + add-ons Strong incentives for cost-cutting; provides incentives designed to reflect regulatory objectives (could be suitable for DH where there is limited competition from alternatives) 4
Current situation in Baltic States and Poland (I) Current regulatory regimes - low levels of regulatory engagement with stakeholders - limited transparency and lack of justification of decisions - lack of proportionality in investigations - lack of high-powered incentive regimes (eg, uncertainty over CAPEX recovery in context of short control periods) - customer non-payment Obstacles to regulatory change - fuel poverty and political salience of heat prices - scope for political intervention in regulatory process - low regulatory capability - dominance of public and municipal ownership Key steps for moving towards best practice - transparency and clarity in regulatory decision-making - investment and certainty of cost recovery - potential and incentives for efficiency improvements - potential to simplify cost assessments and regulatory burden 5
Current situation in Baltic States and Poland (II) Other external pressures for change - a need to develop stepwise approaches towards heat market liberalisation, along with EU and national energy strategies and policies - ensuring long-term affordability of energy (including heat) - incentivising heat production from local, more stable renewable fuels (biomass, waste) away from costly fossil fuels (gas) - a need to make energy policy more independent from social policy Key issues that need addressing - duration of price controls and degree of regulatory burden - mechanisms to ensure long-term cost recovery in particular, allowing an appropriate rate of return on debt and equity - using appropriate benchmarking tools to incentivise cost efficiency - developing mechanisms to transition from current regulatory frameworks to best-practice regulatory regimes and more cost-reflective tariffs 6
Regulatory guiding principles to ensure well-functioning DH markets Investors A regime that: - is clear and transparent - allows investors to earn a reasonable rate of return on their investment - creates incentives for private investment 7 A regime that: Consumers - leads to lower prices in the long term (eg, by providing strong efficiency incentives) - leads to better service quality - prevents unfair pricing practices A regime that: Need for gradual transition from the current regimes in Baltic States and Poland Regulators - contributes towards cost-reflective pricing - creates high-powered incentives to promote a sustainable DH sector - attracts private investment to the sector which can be used to promote efficient use of DH DH companies A regime that: - allows recovery of efficiently incurred costs, including a reasonable return - has appropriate incentives for efficiency and output delivery - enables business planning and allows a degree of commercial discretion - does not generate an unfair regulatory burden
Overview - context: models of regulation - overview of RAB/WACC - approach and recommendations - implementation 8
Towards best-practice price regulation Ex post review supported by ex ante rules The three basic components are as follows: Regulatory timeline Ex ante rule-setting Within-period monitoring and interventions Ex post review RAB mechanism and capital costs Valuation of asset base Roll-forward Stranded assets WACC Outputs, prices and quality Delivering desired outputs at an appropriate price Incentive mechanisms to ensure cost efficiency and quality of service It is recognised that as not all of these changes may be implementable at once, there may be a need to identify priority areas of change The approach would be consistent with the regulatory guiding principles, while ensuring that customers are protected by paying a fair price for heat 9
Ex post review supported by ex ante rules Towards clearer, simpler rules Key steps involved in review process Key ex ante steps Within-period review Key ex post steps Definition of ex ante rules for treatment of cost, and of revenue, output and quality targets Development of targets for next period on the basis of past performance Monitoring of a balanced scorecard to ensure compliance with ex ante rules Within-period adjustment mechanisms if required (eg, changes in fuel prices) Assessment of returns against allowed levels, with claw-back if required Assessment of efficiency against targets (at same time as assessment of returns) Contributes to ensuring compliance within review period Ex post review gives incentives for compliance An ex post regime supported by ex ante rules - the primary job of a regulator is to define rules for allowable cost and for quality, and then to monitor, reward or penalise companies for their compliance with these rules and targets 10
Issue-specific benefits The expected advantages of the proposed system Area of impact Protection for customers Expected impact - ex ante methodologies embed customer protection, while ex post mechanisms provide powerful incentives for compliance; incentives and mechanisms for cost efficiency mean that customers benefit over the long term - within-period review ensures that customers are not exposed for up to five years - more transparent approach to regulation allows for improved understanding of implications of investments for fuel poverty - provides justification of any price changes that have an impact on affordability Attraction to investors Flexibility for companies and regulators Limited incremental regulatory burden Consistency with precedent 11 - offers a stable, transparent regulatory process that gives firms discretion to set prices in line with agreed methodologies - RAB/WACC principles well understood by investors - companies have discretion to set their own prices subject to defined methodologies - regulators do not have to specify or evaluate ex ante the nature and scope of investment programmes; these are decided by the company and reviewed subsequently - no ex ante review and therefore limited incremental impact on regulatory resources - companies responsible for calculating the parameters of the price cap, and demonstrating their consistency with methodologies and related rules and obligations - RAB/WACC model widely used in infrastructure sector - other ex post regimes show that principles can work
Overview - context: models of regulation - overview - approach and recommendations - implementation 12
Key aspects of best-practice regulation 1. Price control based on RAB/WACC principles 2. Sharing of efficiency gains between customers and companies, and cost benchmarking 3. RAB valuation 4. Principles for including assets in the RAB (including treatment of working capital) 5. Cost of capital 6. Customer protection 7. Transitional arrangements 13
Price controls based on RAB/WACC principles Introduction to RAB mechanism - RAB/WACC models are designed to allow regulated firms to recover some measure of their costs - these costs are typically presented as building blocks consisting of: - operating expenditure (OPEX) here, incentives come from an ex post review - depreciation on the RAB (the return of capital) the rules for valuing the RAB and adding assets to the RAB are set out ex ante. Any additions are reviewed ex post to ensure compliance with these rules - return on the un-depreciated RAB (the return on capital, calculated as the WACC times the outstanding RAB) the rules for calculating the return (WACC) are set out ex ante - the version of the RAB mechanism proposed reflects, and is supportive of, an ex post regime underpinned by ex ante rules Ex post efficiency assessment Ex ante rules for inclusion of CAPEX in RAB (reviewed ex post) Starting RAB or asset register Allowed CAPEX Opening RAB Total RAB Allowed OPEX + Allowed depreciation + Allowed return = Allowed revenue 14
Price controls based on RAB/WACC principles Duration Moving to a longer price control period - allows companies time to secure cost efficiencies and retain the associated benefits before sharing them with customers - this allows companies a degree of discretion to find innovative means of reducing cost that may not emerge under more frequent, ex ante reviews - reduces the regulatory burden relative to the existing practice, by increasing the time between price reviews The proposed duration of the price control is five years - a five-year regulatory period is in line with the period established in many countries and industries, and seems suitable for regulation of DH in Estonia, Latvia, Lithuania and Poland The approach allows for within-period reviews to account for any material change in circumstances. As such, regulators do not have to wait up to five years to act in response to specific concerns 15
Sharing of efficiency gains between customers and companies Incentives to encourage efficiency drive value for customers central to the approach Efficiency improvement - increased cash/allowed revenues - lower customer prices Benefits of improved efficiency are shared with customers - efficiency incentives have been successful in driving out costs to users from regulated industries in a number of sectors and countries - both customers and private investors are likely to place a high value on appropriately designed regulatory mechanisms to support efficiency - important role for benchmarking - the rationale for benchmarking is to replicate competitive market incentives to reduce cost by reflecting company-specific and industry-wide efforts to cut cost in different ways and thereby increase profit 16
Efficiency benchmarking in an ex post regime The incentives Carrots: encouraging good performance - firms can retain the benefits from efficiency gains arising from reduced operating cost until the next ex post assessment or even longer, depending on how excessive returns are defined and treated (this could weaken incentives) - frontier companies (ie, the most efficient ones) should be provided with additional rewards Sticks: penalising poor performance - the ex post efficiency benchmarking implies that firms that earned excessive returns relative to the estimated efficient cost base (either because returns were excessive or actual costs were significantly higher than the efficient cost base) will have tariffs adjusted in subsequent years - if thresholds exist and are breached, or companies are identified as inefficient, the regulator can opt for a more intrusive investigation, with the potential introduction of ex ante regulation or adjustments to tariffs in subsequent years 17
Benchmarking DH/CHP operators Aspect Level of comparison depends on data availability and consistency: can be regional, national, or international Recommendation Model at the aggregate level using national-level data. Group- and firm-level analysis to be pursued, with the former accounting for the shared fixed costs of firms within a group At a later stage, possible to extend to an international level Continue to develop standard definitions and methodology for data collection, and adjust for regional factors and atypical costs to normalise costs Possible to compare companies based on their size of operation, fuel used, etc Benchmark companies in groups of similar technological characteristics (eg, fuel technology used) Directly account for company-specific operational factors in the model (eg, economies of scale, customer density/market penetration, customer composition, etc) Costs to be included in benchmarking analysis Depending on data availability, other aspects could be modelled Treatment of input prices 18 Include as many costs as possible Benchmark fuel costs, costs of electricity generation, and other OPEX, and jointly including CAPEX at the TOTEX level Explore use of multiple inputs, multiple outputs and exogenous factors, depending on the data Benchmark at the national level by grouping companies of similar technology (eg, fuel type)
RAB valuation (I) Replacement cost (RC) as a regulatory target Efficient market outcome Inter-generational equity - DH networks are different from traditional utilities as there is some competition with alternative sources of heat (at least at the installation stage) - using RC would promote efficient use of alternative sources of heat in the long term - using RC ensures that each generation of customers pays for the actual value of the asset used to supply the service Ensuring that companies are financeable Facilitating benchmarking - using RC produces a depreciation profile that matches more closely actual expenditure on asset renewal, reducing the mismatch between cash outflows and cash inflows - using RC ensures that companies adopt similar cost capitalisation and depreciation policies, making asset values more comparable across the industry 19
RAB valuation (II) - main challenge in moving to the RC approach if the gap between RC and HC is large, a move to RC might imply a large increase in tariffs, which might be inconsistent with affordability objectives - for newer assets the gap will not necessarily be large, but it may be so for older assets How could the change to RC be managed? 120 110 100 90 80 70 60 50 Asset value based on what it would cost to replace the asset today Asset value based on historical cost ('legacy' assets built a long time ago) gap between RC and HC: over time would need to be closed as old assets will need replacing RC HC time One option, as a transitional arrangement, could be to use a hybrid between RC and HC - depreciation is based on asset values calculated using RC, while returns are based on asset values calculated using HC - example: assume HC = 60, RC = 100, cost of capital =10%, average asset live = 20 years, and straight-line depreciation; then allowed return = 6 (10% of 60) and allowed depreciation = 5 (100/20) - could strike a balance between efficiency and fairness arguments: customers are charged for the current opportunity cost of assets, while investors recover only their actual investment without windfall gains - this type of approach is used in the water sector in England and Wales - main practical complication would be the need to estimate both RC and HC 20
Principles for including assets in the RAB Which types of assets are allowed in the RAB? When are the new assets added to the RAB? At what cost are the new assets added to the RAB? - only used and useful tangible assets - rules for passing the used and useful test are set ex ante - an appropriate allowance for working capital - added either when the funds are expensed or when the new asset becomes operational - in the latter case, the financing costs of construction work in progress are added to the final cost of the asset - added at forecast acquisition cost - ex ante rules specify how the opening RAB in the next regulatory period is to be adjusted to reflect differences between the actual and the forecast expenditure that was used to set prices at the beginning of the period - the regulator reviews the cost ex post - ex ante rules define how the regulator will carry out the review 21
Principles for including assets in the RAB Treatment of working capital What is working capital? Accounting - the difference between current assets and current liabilities - current assets include inventories, cash required for operations, marketable securities, accounts receivable, other receivables - current liabilities include accounts payable, other payables Regulation - primarily relates to receivables less payables; also includes inventories where applicable - excludes cash and interest-bearing securities (financial working capital) - capital that is required to cover the time lag between an expense being incurred and revenue being received Why should working capital be included in the RAB? - working capital is needed for business operations, and therefore satisfies the used and useful principle - the defining characteristic of working capital is the short-term timeframe over which it is locked into the RAB. As with other capital, it generates an opportunity cost that should be remunerated at the cost of capital - in addition, regulatory precedent is consistent with compensation for working capital - for example, the Italian energy regulator, the water regulator in England and Wales, and North American energy regulators have made adjustments for working capital 22
Cost of capital: what is it and why is it used? - the cost of capital is the cost to a company of raising finance (debt and equity) to support investment programmes - it represents the opportunity cost to investors of putting money into one type of asset as opposed to their alternatives - on average, in a competitive market, returns paid by firms to investors trend towards the cost of capital - regulators estimate the cost of capital to determine allowed returns - the cost of capital is the percentage that is multiplied by the RAB to determine the allowed return component of allowed revenue - setting a cost of capital below the true opportunity cost of funds can lead to an underinvestment problem Companies that outperform the regulator s assumptions on costs can earn more than the cost of capital, and vice versa - allowing companies to earn extra returns if they are more efficient than the industry on average is key to incentivising investment and further efficiency 23
Cost of capital High-level best-practice principles in estimating the WACC - a company s cost of capital cannot be measured directly; it can only be estimated - important to balance theoretical accuracy with the practicality required for developing regulatory regimes in the four countries, taking into account the limited availability of country- and industry-specific data - best practice for estimating the WACC involves thorough analysis, taking all relevant evidence into consideration - methodological proposals and parameter estimates should be subject to a formal consultation, with opportunities for contributions from all stakeholders - the estimated WACC should reflect the risk of those DH activities that are subject to regulation. Proposals provided in the appendix reflect the cost of capital of DH network activities: - if returns on generation activities (eg, CHP) were subject to regulated returns, the parameters for the equity beta, debt premium and gearing in the comparator analyses would need to be adjusted 24
Customer protection Principles and recommendations Clear and transparent regulatory framework - ensuring customer protection is one of the regulator s statutory duties - develop ex ante a system of rewards/penalties based on customer satisfaction metrics - adjust revenues for the next regulatory period at the ex post review or at the within-period review (subject to clearly defined ex ante conditions) - define what an unacceptably large price increase would be in each country - develop rules for transition to the new regulatory regime and revenue re-profiling tools that the company can use in setting prices Customer engagement - ensure that the regulatory process is transparent, with customers able to comment on the proposed framework through a customer representative group Most effective tool for protecting customers a clear regulatory framework that limits the scope for discretion by both regulator and companies, and within which compliance with ex ante rules can be monitored effectively 25
Transitional arrangements Balancing affordability and investment needs - transition to higher prices, if justified, should take account of both affordability concerns and the impact on investment, quality and service provision by DH companies - rapid and significant increases in prices will pose difficulties for users but long transition periods may make it difficult for DH companies to finance investment - possible tools available to a regulator (reflecting precedent) to mitigate the impact of price increases to address affordability concerns include the following: - modifying depreciation profiles - this will not affect the net present value of cash flows, only their timing, such that the company recovers more at future dates than today and the impact is spread over time. Note that this may cause financing concerns as there could be negative impacts on cash flow - deferral of CAPEX, and delay of entry of CAPEX into RAB - capitalisation into RAB of what is considered OPEX - profiling of returns over time, so that they are higher towards the end of the control period 26
Overview - context: models of regulation - overview of RAB/WACC - approach and recommendations - implementation 27
Implementation: main conclusions - the principles of RAB/WACC-based regulation have the potential to deliver value to consumers, and to provide a supportive environment for investment - customers protected by ensuring cost-reflective prices and incentivising cost reductions without jeopardising service quality, which is critical given political emphasis on affordability - ensures that the company recovers all efficiently incurred costs and earns an appropriate return (ie, commensurate with the level of risk taken) on invested capital - employed in a number of countries across a wide range of sectors - lessons from regulatory precedent can help to address specific issues that may arise in different countries and in developing proposals that deliver value for consumers - ex post regimes may be expected to reduce regulatory burden and allow the company greater flexibility to set prices - it is recognised that there is a need to address any practical issues that may be encountered in the implementation of these proposals, and to account and adjust for these issues as appropriate It should be possible to develop supportive regulatory regimes that account for the specific characteristics of individual countries based on the proposed framework 28
Appendix 29
Appendix: price control building blocks Building blocks Determine the outputs Forecast the expenditure What do customers want? What is important to society and the environment? Is there a willingness to pay for improvements? How can OPEX be assessed? How can CAPEX needs be assessed? Scope for future efficiencies in OPEX and CAPEX? Determine allowed revenues How should CAPEX feed into allowed revenues? How should OPEX feed into allowed revenues? Tariffsetting Key choice Convert into customer bills Apply incentive regime What is the appropriate price structure? What is the appropriate form of control? How should costs be recovered? Are specific bolt-on incentives needed? 30
Appendix: applying the incentive regime Form of control Structure of charges Task-specific incentives (bolt-ons) - incentive-based? OR - rate of return/cost of service? Key issue is treatment of costs - how to recover the costs of the business? - single product, or multiple products? - price or revenue cap? - quality of service - types of financing - risk reallocation - overcoming information asymmetries 31
Appendix: example of econometric methods for benchmarking OPEX Inefficiency A D F E OLS benchmark (average) COLS frontier Customer density or market penetration 32 B C MWh Econometric approaches make comparisons more like-for-like by taking into account factors that differ between companies (eg, customer density could be a third dimension). The above two dimensional representations on the OPEX MWh plane take into account economies of scale (ie, larger companies have lower unit costs) An industry frontier (rather than an average cost function) can be established by parallel-shifting the OLS regression line until it envelops all firms (the COLS frontier suggests that only C is efficient)
Appendix: cost of capital Weighted average cost of capital - the cost of capital for a firm is typically estimated as the weighted average of the costs of different types of financing sources - costs of equity (R e ) and debt (R d ) - weighted by the proportion of equity and debt in the total value of the business eg, the cost of debt is weighted by gearing (g), where: g is typically defined as net debt/rab and net debt is the amount of long- and short-term debt, minus cash or other cash-like assets - European regulators typically estimate the WACC using the capital asset pricing model (CAPM) 33
Appendix: cost of capital Estimating the cost of capital: CAPM and WACC Weighted average cost of capital under CAPM Equity/ total value Cost of equity (R e ) Debt/ total value Cost of debt (R d ) Country risk premium Risk-free rate Equity risk premium (ERP) Equity beta Asset beta Debt beta Debt risk premium The WACC is the weighted average of required rates of return to different types of financing sources, weighted by the market value of those financing sources. For two types of capital (debt and equity) where gearing (g) = D/(D+E): WACC = R e x (1 g) + R d x g 34
Proposals for cost of capital Summary of DH WACC parameters Parameter Key evidence used Base methodology Risk-free rate Sovereign risk premium Equity risk premium Beta Index-linked French and UK government bonds of 10-year maturity; nominal yields on German bonds Poland: current rates on 10-year sovereign bond yield less the risk-free rate Latvia, Lithuania, Estonia: sovereign CDS spreads of maturity consistent with the risk-free rate (10 years) less the sovereign CDS of the country whose bond is used to calculate the risk-free rate DMS long-run ERP in Europe (UK, Germany, Europe overall); implied equity market volatility Asset beta estimates for comparable companies; raw betas and Blume-adjusted betas; using data over various frequencies and time periods Construct a range based on current market rates Add to the post-tax cost of equity. In cases where debt premium comparators are domiciled in countries with minimal sovereign risk, an equivalent adjustment should be made to the debt premium Apply the DMS ERP directly; ERP should be based primarily on arithmetic average Construct a range consistent with the raw and adjusted beta estimates Debt premium Current debt spreads of comparable companies; cross-checked with historical averages and corporate bond indices Construct a range based on comparators; with an adjustment for sovereign risk if comparators are domiciled in different countries Gearing Inflation Based on market values of debt and equity. Consistent with gearing levels of companies with credit rating comparable to target credit rating of DH networks; and with regulatory precedent Independent forecasts, such as those provided by central banks Construct a range consistent with the observed evidence Inflate the real risk-free rate by the inflation forecast using the Fisher formula: (1+r) (1+π)=(1+i) 35
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